The coronavirus, or Covid-19 pandemic, has thrust the world onto a path leading to an economic collapse of epic proportions. In this constantly-updated blog we follow the progress of the crisis.
The Stage of the Crisis: The Counterattack/The Flood
Updated 22/10/2020 (previous update 13/10). All updates are presented in bold.
In the December 2018 issue of our Q-Review, we outlined the likely scenarios of an approaching global economic collapse. But, like most things in life, such a dramatic event is unlikely to proceed in a purely linear fashion. There will be different stages within it.
In December 2019 we outlined these stages, which are likely five: the onset, counter-attack, flood, calamity and recovery. Here, we briefly define the characteristics of each, updating them with recent information.
The Onset of the crisis
In the Q-Review 4/2019, we specified that at the onset, stresses that had been building in the credit markets since the summer of 2019 would explode, shrinking if not eliminating entirely the exits from many parts of that market.
Downgrades of corporate debt in the U.S. and peripheral sovereign debt in the Eurozone would push large fixed-income investors, including pension funds, into higher-rated bonds, which would in turn lead to large-scale selling of lower-rated bonds, forcing wider spreads and even more selling.’
This moment came in late February 2020, when a sudden panic gripped investors in both credit and equity markets after a surge in reported Covid-19 cases and deaths in Italy coincided with the collapse of OPEC talks. Stock markets crashed and spreads in the credit markets exploded. A frantic retreat to ‘safe-haven’ assets, including U.S. Treasuries, German Bunds and U.K. Gilts as well as cash and precious metals commenced.
For a brief period of time in mid-March, we were on the brink of a complete financial market meltdown. Then, as we also had envisaged in December, there was a frantic rush on a never-seen-before scale by global and local authorities to rescue the situation.
We envisaged that the second phase of the collapse would be the desperate efforts of authorities to stop the crisis by a counterattack.
We said these were likely to include the restarting and acceleration of QE programs and other market support initiatives, gigantic fiscal stimulus, increasing trade protectionism and possibly even calls for direct debt monetization (see Q-Review 3/2019 for an explanation).
These tactics have been employed in full force. Governments all over the world have pushed vast amounts of debt-financed stimulus into their respective economies. However, this astronomical level of stimulus has only resulted, at best, in a sub-par recovery across the globe, which is now fading.
Moreover, this ludicrous level of fiscal stimulus has degraded the effectiveness of the ‘ammunition’ which remains to governments to respond to the approaching, and most-dire stage of the crisis: the “Calamity”.
The Fed has now become the financial market as it backstops U.S. Treasury markets, intervenes in corporate commercial-paper and municipal bond markets and short-term money-markets. Massive support by the FED and the “free money”-schemes of the government have levitated U.S. stock market valuations to levels not seen since, at least, the height of the “Tech Boom” in 1999.
The ECB has effectively reached the bottom of its reserves of resuscitation. Stock purchases, etc., would be utterly ineffective considering that the Eurozone fell into recession in Q4 2019, in the midst of “QE-forever” announced by M. Draghi in September.
Moreover, “helicopter drops” of money would be technically very challenging in the Eurozone and debt monetizations are strictly forbidden in the currency block. Political opposition to them would also likely to be fierce, at least in Germany.
While the European leaders reached an agreement on the €750 billion “recovery fund”, it will still need to pass all 27 national parliaments. This is far from certain.
The Eurozone, with its massive and teetering banking sector, is the ‘weak link’ in the global Counterattack.
Regardless of the desperate efforts of global authorities to uphold the credit and stock markets, we are still facing a flood of corporate bankruptcies.
In December 2019, we asserted that the so-called “zombie” corporations, faced with collapsing global economic demand will start to fail on a scale unseen in decades. Unemployment will skyrocket and tax revenues will collapse. And, at some points, credit markets will crash despite of the massive efforts of central banks. We also envisaged that:
If one or more European banks weakens or fails, it will be likely to send the capital markets into a similar downward spiral.
Next, we detail the Flood phase in three crucial countries/areas: the U.S., the Eurozone and China.
The United States
Soon, the zombie corporations may represent 20% of US firms, the percentage of which is now increasing fast due to the unprecedented support operations of the Fed and the U.S. government, increasingly, one and the same.
The “Flood” has now clearly began in the U.S. Statistics by the American Bankruptcy Institute show that nationwide bankruptcy filings surpassed the 2019 level in September.
We can only imagine what the level of Chapter 11 filings would have been without the massive government support. But the fact remains that the US government, or any other government for that matter, cannot keep the tide of corporate and personal bankruptcies at bay forever.
That’s why we believe we are only at the beginning of the Flood, where you perceive that the water is slowly rising—and you know that it will get much worse.
Europe currently holds an unknown, but potentially a very large number of ‘zombie’ corporations. Their existence is also tightly connected to the existence of weak (or zombified) banking sector of Europe.
Moreover, over half of small and mediums-sized business in Europe say they face a bankruptcy next year if their revenues do not improve.
Now, as moratoriums end in parts of the Eurozone Germany, for one example, is facing a deluge of insolvencies. Debt moratoriums will end in Italy during H1 2021, with the first instances ending right at the beginning of the year. This is likely to lead to a catastrophic increase in non-performing loans in Italian banks.
The profitability of European banks after the GFC has also been dismal, and as we explained in Q-Review 3/2019, these banks have been hamstrung both by OMT and QE programs and the negative rate policy imposed by the ECB.
The ECB’s stress test, published in October, showed that half of the biggest banks in the Eurozone would not survive if financial counterparties and some commercial clients pulled their money from the banks. This is exactly what happens in a recession, which has now arrived.
The onset of the European banking crisis is close.
The economy of China is recovering, slowly, but only because of the massive stimulus (see Figure 2). Banking problems are also becoming more pressing in China.
Profits are plunging in China’s $45 trillion banking system at the fastest pace in at least a decade, bad debt has hit a record, and capital buffers are eroding. Also, for example, China’s four biggest banks face a combined $940 billion shortage, mandated by 2024, to meet capital requirements designed to protect the public and the financial system against massive bank failures. It is therefore no surprise that the share prices of Chinese banks have plunged to record lows.
The ‘hard landing’ of the Chinese economy is on the horizon.
When corporate failures, or the Flood, truly begin, this will be visible both in the financial markets and in the public sector. Several sectors of the financial markets are likely to witness massive turbulence, collapsing prices and even complete implosion, similar to the recent cataclysm in the oil markets.
The “Flood” will have the biggest impact on the banking sector, which is already very weak in Europe. The Fed and other central banks may be able to uphold the financial markets, but their ability to stem a banking panic is very limited.
In reality, central banks can only provide liquidity and try to establish a ‘bad bank’ to collect non-performing assets from bank balance sheets, but if the problems of the banking sector are widespread, as they now are, these methods will be insufficient to stem the ‘bank run’. Only governments can truly solve a banking crisis, by, for example, providing fresh capital to banks, but many are heavily indebted now, especially in Europe.
An utter economic collapse, Calamity, will follow.
Massive global deflation will appear, led by an ugly chain of bank and corporate failures. Global liquidity will collapse and stock markets will crash in a spectacular fashion.
The value of the holdings of public and private pension funds, charitable endowments, bank trust funds, insurance company general and variable accounts, and stock and bond mutual funds will crash in short order in the Flood. Even lowly money-market funds may be at risk, just as they were in the 2008 financial crisis.
Due to both crashing capital markets and banking sector bankruptcies, joblessness and poverty are likely to explode. Simultaneously, government tax revenues will collapse as incomes retreat and capital gains evaporate.
As governments spending skyrockets in an orgy of Keynesian counter-cyclicality, national deficits will hit all-time highs on both an absolute and relative basis. Those central banks that have initiated debt monetization will have no alternative but to accelerate their programs. In their desperation, many other central banks are likely to follow.
Governments will try to save critically-important banks, which will require large-scale funding many countries—such as those in the Eurozone—cannot afford and will not be able to finance in paralyzed capital markets. This economic reality makes depositor bail-ins the only, if politically-unpalatable, option.
Confronted by new and harsh fiscal realities, pensions and other social security programs are likely to face serious cutbacks, by desperate governments. An economic calamity sets in.
However, even grimmer scenario exists. If countries worldwide are forced to reinstate broad and draconian lockdowns due to the second wave of the coronavirus pandemic, this could lead to the complete breakdown of global supply-chains. Global logistics routes would be disrupted by huge numbers of sick (or frightened) employees and the strict closures of both factories and national borders.
These ghastly factors, combined with soaring unemployment, business failures and market turmoil would topple the global banking sector. Bank losses would be likely be so great that though depositor bail-ins would be enacted, they would be insufficient to keep banks from failing.
The European banking sector would be likely to collapse completely, followed by an implosion of the global financial order. Global commerce would evaporate. The world would succumb into utter economic annihilation.
The only way to save the world economy would be enact full-scale socialization. This would mean never-before-seen central bank action.
The Federal Reserve and other central banks would need to buy not just government bonds (as they have already in QE) but the majority of the universe of financial risk assets, which is estimated to top 400 trillion US dollars. Moreover, central banks would need to provide practically limitless fiscal support for governments to uphold or even increase their consumption and investment activities.
In this scenario, the balance sheets of major central banks would turn into investment vehicles with limitless boundaries.
Central bankers would decide which countries and corporations would survive. They would effectively metastasize into Gosbanks (the central bank of the now-defunct Soviet Union) of the world. This would naturally lead to an utter, unrecognizable, global economic dystopia.
If the full socialization of our economies and financial markets does not occur, we expect the global depression to last 3-5 years. The initial collapse is likely to be over within three years (2020-2022).
Thus, the path to recovery will depend crucially on how far the ‘cleansing’ of the economy, markets and financial sector is allowed to go. If the banking sector implodes completely, the economic deficit will naturally be made much deeper leading to a systemic crisis.
However, if the essential functions of the banking sector are sustained, especially in Europe, we could avoid the deepest malaise. Moreover, if unsound banks and “zombie” corporations are allowed to go under or are wound-down methodically, it will clear much of the malinvestment from the economy, creating the foundation for a strong and sustained recovery.
So, if we manage to return to the principles of the market economy including, most crucially, a return to undistorted price discovery in the capital markets, we are likely to see one of the most powerful recoveries in global economic history. It would be led by robotization and general technological innovation, which hard economic times tend to foster.
However, debt monetization, Modern Monetary Theory (“MMT”), helicopter drops and other money-conjuring schemes would corrupt the economy further making a sustained recovery impossible (see more from Q-Review 4/2019). This, unfortunately, is the path we currently are on.
Moreover, with the governments and the central banks assuming a much bigger role in the economy and society in this darker scenario, some form of fascism (which is, by definition, the merger of state and corporate power) would be the likely end-result of these developments.
We can do nothing more than hope that wise, courageous and far-sighted political leadership will spare us from that horrible fate.
Following the coronavirus outbreak, junk bond yield-spreads shot-up. They were tamed by massive support operations launched by the Fed, which have also pushed stock markets to new heights (see Figure 3), while corporate bankruptcies run at record levels. This makes absolutely no sense.
It’s clear that the ‘zombified’ junk-rated companies cannot endure elevated yields and collapsing demand for very long before they start to fail. The massive unemployment already visible in many countries, is likely to be the main driver of corporate bankruptcies worldwide.
Moreover, firms cannot not survive on debt alone. They need income, which the central banks cannot print. Record levels of bankruptcies mean that unemployment will not improve significantly, and the central banks cannot print jobs. Central banks also cannot print bank profitability.
And now, the second wave of the coronavirus pandemic looms. That is why are in the verge of a global economic collapse driven by a vulnerable real economy and a fragile and over-levered financial sector.
We are at the interim stage between the Counterattack and the Flood.
Global authorities may still be able to postpone the onset of the banking crisis for few months, but the massive banking losses inflicted by the coronavirus and the emerging Flood guarantee that its coming.
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